Archive for July 2011

According to a recent paper by Vanguard, most individual investors still don’t do very well when it comes to selecting mutual funds. For those of you who really like to get `deep in the weeds’ on this stuff, you can read it here

This is an issue affecting many company retirement plan participants who have plans offering a long list of mutual fund selections.

Many plan sponsors – mistakenly, I think – believe that if they offer a huge menu of funds and turn all decision-making over to their participants, they’re `off the hook’ for the participants’ investment decisions.

Not sure that’s so. I’m no attorney – if you’re a plan sponsor, you may want to discuss this with your ERISA attorney – but it seems to me that plan fiduciary’s first and only consideration should be to act in the best interest of plan participants.

DALBAR Financial Services tracked investor’s behavior chasing market returns from 1987-2006[i]. During that 20-year period, the S&P 500 yielded an average annual return of 11.8% while the average investor realized only 4.3%, clearly demonstrating that the vast majority of plan participants lack the knowledge, skill, and discipline to make good investment decisions.

So why do most plan sponsors simply offer a menu of high-priced retail stand-alone mutual funds – or worse, a bundled package assembled by a `big name’ company selling a high (hidden) priced product – instead of seeking out professional investment management solutions? My guess is it’s simply a matter of a long history of drilled-in programming. Let’s face it, many plan sponsors have been sold a `bill of goods’, some even believing their plan is `free’; but, asking participants to assemble investment portfolios is like asking them to assemble all the parts of an automobile and expecting them to reach their destination!

The Vanguard paper and the DALBAR study are just two in a long list that reach the same conclusions. Plan sponsors need to ask themselves: Are their participants really better off self-managing their retirement assets? Should we really be asking them to do something they’ve never been educated to do? – Let’s face it, many truly believe they know what they’re doing, but often their only education was a weekend class learning a trading system – or they read consumer magazines

Prudent plan sponsors – `prudent’ does have a legal definition in ERISA – who truly understand their duty is to act “solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries” may want to consult with a plan consultant about their options.

Jim

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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and an Accredited Investment Fiduciary® now in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.

You’d be surprised how many business owners think their 401(k) plan is free. It’s a ridiculous assumption, but many believe it. It’s not their fault, though. The landscape were designed to be confusing, they couldn’t have done a better job of it.

Retirement plans are regulated under the Employment Retirement Income Security Act (ERISA) with the purpose of protecting plan participants. Once you realize that the plan participant, not the plan sponsor, is ERISA’s priority, you’re on your way to understanding fiduciary liability.

Now, I’m not an ERISA attorney, nor did I stay in a Holiday Inn Express last night – and plain English explanations require a little over-simplification, so I’ll take a shot at it. But, be sure to discuss this with your attorney. Okay, here’s the oversimplified, plain English inside look:

Who’s a Fiduciary?

If you sponsor a plan, you’re a fiduciary under ERISA. If you make decisions concerning the plan, you’re a fiduciary, regardless of your title – you can be the company janitor and still be a plan fiduciary. If you give plan advice, you can be considered a fiduciary – even if you’re a receptionist. The fiduciary’s primary responsibility is to the plan, i.e., plan participants.

Why it’s important: Fiduciaries can be held personally liable for their decisions. Yes, personally. No corporate veil protections. ERISA won’t allow plan fiduciaries to hide behind the company when participant money is involved. Problems generally arise when a fiduciary is held to have breached their fiduciary obligations with regard to the plan. Most often, this happens due because of a failure to follow and document a prudent process in carrying out their duties or when a `prohibited transaction’ occurs – something that’s a little too complicated to go into here; but, it is a issue worth discussing with your ERISA attorney. Note: You need an ERISA attorney. The one you use for your estate plan isn’t the one you need.

The Players

Plan Sponsors: Individuals or companies that sponsor 401(k) plan(s) for their employees.

Plan Fiduciaries: Those who make decisions regarding the plan.

Plan Participants: The employees who each have their own retirement accounts inside the plan.

The Record Keeper: Generally the plan provider. The record keeper makes sure plan assets are recorded to participant accounts and provides reporting services. These are not fiduciary functions; they’re administrative. Plan providers are vendors.

The Plan Financial Advisor: Traditionally, this has been the plan salesperson who sells the `bundled’ solution to the employer for a commission. This role is changing drastically as more plans are using fee-only Registered Investment Advisors to provide plan consulting services instead of commission-based brokers, for reasons you’ll soon see.

The Plan Investment Manager: The investment fiduciary – the one who makes the investment decisions. The one who has the final say on the investment line-up (which funds and options you include) is the investment manager; and this IS a fiduciary function. You may think you’re not the manager; but you’d better consult your vendor agreement – chances are YOU are the investment fiduciary.

The `Shell Game’

Since plan sponsors are becoming more aware of their potential liabilities, plan providers have come up with a marketing gimmick. They call themselves `co-fiduciaries’ in their marketing material, but expressly avoid any such liability by limiting their `advice’ to line-up `recommendations’ and participant education, i.e., they do not provide actual investment advice to participants. The marketing leads sponsors to believe the provider is `taking care of everything’, but they’re sadly mistaken. Remember, the provider is still only a vendor. The choice of provider is a fiduciary act. The fiduciary must act in the best interest of the plan, i.e., the participants.

Most vendors like selling a ‘bundled’ solution. The reason is simple: It’s easier to sell and they can make the plan look `free’ to an unsuspecting plan sponsor.

Note: Our government is designed with three branches: Executive, judicial, and legislative. The purpose of the design is to provide a `checks and balances’ so that no one branch can control government. Indeed, this hasn’t always worked, particularly when one party controlled all three branches.

A good plan has three components: Recordkeeping, administration, and investment management. When these three functions are handled under a ‘one-stop shop’, it’s often a recipe for abuse, with the plan sponsor left on the hook as the fiduciary holding the bag.

Example: ABC Wigits wants a `free’ plan. The company president is told by a vendor they can handle everything! They are a third-party administrator who can handle design, record keeping, and everything else, top to bottom. What’s more, it’ll be dirt cheap!

It’s all done with revenue-sharing – something I liken to `kickbacks’ – TPAs hate it when I use that term. But, you tell me what it is when money is steered to specific mutual funds who, in turn, pay revenue sharing to the TPA? And, some mutual funds companies pay higher revenue sharing than others – so, guess which ones get chosen for the fund line-up?

Would YOU call that a fiduciary best practice on behalf of your participants? Choosing revenue sharing funds is a common practice, with the `kickbacks’ used to defray the fees TPA’s charge to the account balances of plan participants.

Do you doubt the plan’s commissioned sales person is selecting funds that pay the most revenue sharing? After all, if s/he’s commissioned on the revenue generated for the TPA firm, that could represent a conflict of interest. No wonder, they don’t really want fiduciary status for investment selection.

There’s nothing illegal about any of this. Indeed, responsible TPAs are now getting out front by disclosing all revenue sharing used to offset fees and are not trying to line their pockets. But, that doesn’t get plan sponsors ‘off the hook’. After all, they are the ones charged with having a documented process for the selection of all service providers, including the investment line-up. And, eliminating conflicts of interest is an obvious place to begin.

Staying Out of Trouble

Here are five simple tips – again, in oversimplified plain English.

Avoid questionable revenue sharing arrangements that could influence fund selection. Do not use your TPAs in-house investment advisory firm. Keep a Chinese Wall between all players. TPA-administered plans with no financial advisors are even worse because these payroll providers will offer mutual fund lineups while clearly stating they are not offering advice or acting in any fiduciary capacity.

Use an independent plan advisor to develop an investment policy statement (IPS) with plan trustees, conduct vendor searches, provide education at both the plan level (fiduciary) as well as the participant level, where the need is for real help, i.e., advice beyond education. While a ERISA 3(21) fiduciary advisor can advise on fund selection, asset allocation, and investment line-up, they can help plan sponsors who want to truly minimize their liability by helping the sponsor conduct an independent search for an ERISA 3(38) investment manager – which truly transfers the responsibility, and liability, for investment selection to the manager. While liability is greatly reduced, it’s important to remember, the selection of a 3(38) advisor is still a fiduciary act, and you need a prudent process for selection, as well as the in-house education and participant advice component. Your independent 3(21) plan advisor will also be providing monitoring and oversight of your 3(38) managers and, of course, the independent advisor works for the client, not the TPA or record keeper. Your advisor is your guide to an independent, documented, prudent process for the fiduciary issues ERISA addresses.Remember, an investment advisor who is not independent and works for the TPA will always have a dual loyalty. A loyalty to the client, sure; but, also a loyalty to provide a mutual fund line-up that will produce the most kickbacks – sorry, revenue sharing fees – to the TPA firm. An independent advisor is paid from the plan on a fully-disclosed basis and has no incentive to provide revenue sharing for the TPA – indeed, the advisor works solely for the plan and in the best interest of plan participants – and that’s what ERISA is all about.

Use an independent ERISA attorney. The TPA’s attorney, like the sales rep, works for the TPA, not the plan sponsor. Only an independent ERISA attorney will always act as an advocate for the client. Remember, the in-house attorney doesn’t have an attorney-client relationship with you. If a problem arises, guess which side the attorney will take!

Avoid using a ‘one-stop shop’. Checks and balances are one and the plan sponsor is virtually ALWAYS left as the true lone fiduciary at the mercy of the other players. Besides, suppose you’d like to terminate one service provider, i.e., after terminating the TPAs legal department and/or investment services, how do you maintain a working relationship with their administration arm when bringing in others to handle those services independently?

Don’t use your payroll company to run your 401(k) plan. The two largest payroll providers in the country see 401(k)s as a natural ‘add-on’ profit center; but payroll services are an automated, computerized function, and too often they seem to run their 401(k) plans the same way. While they talk about ‘seamless’ integration, I’m not so sure it’s all that seamless. Plan administration has little to do with payroll. The tasks of plan administration, record keeping, investment management, and plan advisory services are simply too many balls to keep in the air. More importantly, the `checks and balances’ plan sponsors need is missing. Further, they seldom if ever offer any real investment advice – nor do they offer a co-fiduciary role. My favorite story is about the TPA/payroll provider `advisor’ who suggested a client add a small cap fund to the lineup and then insisted it wasn’t financial advice, just a suggestion.

This is rather short and admittedly over simplified. Talk to an independent ERISA attorney and an independent plan consultant. They’ll help you through the process of helping you put together your own independent financial group of service providers, each working for you, with loyalty only to your plan.

Beginning next year, this issue will likely show up on the evening news! The reason? New laws kick-in requiring plan providers to fully disclose all fees on participant statements, which means participants will likely start knocking on the doors of plan sponsors asking some questions. Plan sponsors, and participants, who thought their plans were `free’ will likely be in for a shock – and without a documented process, answering questions may prove difficult, especially when the questions come from disgruntled former employees.

Remember, the buck stops with the one who makes the final decision. And, delegation of authority IS a decision.

Jim

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Jim Lorenzen is a Certified Financial Planner™ and An Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.

What every sponsor of a retirement plan should know is that ERISA holds them to the highest standards of being a prudent investment expert – even though they are almost never investment experts. There is a solution to this conundrum.

The Solution: The Employee Retirement Income Security Act (ERISA), the body of law that governs qualified retirement plans such as 401(k) plans, has a mechanism by which a plan sponsor can get rid of its responsibilities and liabilities for the selection, monitoring and replacement of plan investment options. The sponsor can do this by retaining an investment advisor that accepts transfer of these responsibilities and liabilities from the sponsor. This is done through a written contract between the sponsor and advisor in which the advisor is legally bound as an ERISA section 3(38) investment manager. By signing this contract, the advisor becomes an ERISA section 405(d)(1) independent fiduciary to the plan which makes it solely responsible and liable for its investment decisions concerning the selection, monitoring and replacement of plan investment options. A plan sponsor, however, always retains the duty to select, monitor and replace the investment manager.

Few Advisors Are Willing to be Fiduciaries. Few advisors to retirement plans will accept transfer of such significant fiduciary responsibilities and liabilities. Being a retirement plan investment manager is a highly specialized field; and, most plan sponsors would rather have independent help in selecting the manager. This is why a great majority of advisors offer plan sponsors `quarterbacking’ in carrying out the sponsors’ investment-related fiduciary duties. This help is generally comprised of manager search, selection, monitoring services, fiduciary oversight, etc. None of these services do anything to help plan sponsors rid themselves of the significant responsibilities and liabilities they bear under ERISA; but they do provide the prudent process plan sponsors need in carrying out their duties; and it’s the lack of this process that usually leads to problems.

The “Co-Fiduciary” Advisor – Buyer Beware. Not all `co-fiduciaries are really what they seem. Since many sponsors of ERISA-governed retirement plans have become aware that the advisors to their plans should wear the “fiduciary” label, many plan providers have responded to this by creating a marketing gimmick, otherwise known as a co-fiduciary. The term “co-fiduciary” has been hijacked by many in the industry so that they can turn non-fiduciary broker-advisors to retirement plans into fiduciaries. This invented co-fiduciary marketing term has nothing to do with the legal meaning of a co-fiduciary under ERISA law. What’s worse, when the provider (record-keeper), the investment manager, and the administrator are related, the plan sponsor has lost his checks-and-balances – The fox is watching the hen house. Not good for our poor, unsuspecting plan sponsor who thinks he’s covered – or worse, thinks his plan is ‘free’.

An advisor wearing the “co-fiduciary” label accepts no transfer of responsibilities, so mitigation comes from providing help with the installation of a prudent process for the selection, monitoring and replacement of plan investment and management options. The plan sponsor is still holding the bag all alone and bearing all fiduciary responsibilities and liabilities; no protection from Wall Street non-fiduciary broker-advisors that wear the “co-fiduciary” label. But, there are alternatives available:

Retain an investment advisor that’s an ERISA section 3(38) investment manager and transfer significant fiduciary responsibilities and liabilities to that qualified advisor. Sponsors that do this are then no longer liable for selecting, monitoring and replacing plan investment options.

Retain a plan investment advisor that’s an ERISA section 3(21) “co-fiduciary” and receive no relief from fiduciary responsibilities and liabilities for selecting, monitoring and replacing plan investment options or retain a non-fiduciary advisor and receive no relief from any fiduciary responsibilities and liabilities at all.

Retain an independent ERISA section 3(21) “co-fiduciary” to quarterback a prudent process for the screening and selection of a qualified section 3(38) investment manager for the transfer of significant fiduciary responsibilities and liabilities for the selection, monitoring, and replacing of investment options.

#3 should be an obvious and easy one when plan sponsors are informed fully about it.

Does it make sense for a younger investor to invest in his/her 401(k) during a ‘non-bull’ market?

This little exercise might provide a clue as to why most investment experts advise consistent investing.

In our example, the price of our fictitious investment begins and $50 and goes down. In fact, it takes 10 years just to get back to it’s initial price. Did systematic investing seem worthwhile? You be the judge.

Systematic Investing During Difficult Times

Market

Year

Price

$ Amt

# Shares

$ Amt

# Shares

Cum # Sh

1

$50

$20,000

400.000

$2,000

40.000

40.000

-20%

2

$40

0

$2,000

50.000

90.000

20%

3

$48

0

$2,000

41.667

131.667

-25%

4

$36

0

$2,000

55.556

187.222

20%

5

$43

0

$2,000

46.296

233.519

-30%

6

$30

0

$2,000

66.138

299.656

20%

7

$36

0

$2,000

55.115

354.771

20%

8

$44

0

$2,000

45.929

400.700

-10%

9

$39

0

$2,000

51.032

451.732

28%

10

$50

0

$2,000

39.869

491.600

Totals

$20,000

400

$20,000

491.600

Portfolio Value

$20,066

$24,661

Average Cost per Share

$50

$40.68

Value Per Share

$50

$50

Profit Per Share

$0.16

$9.48

Portfolio Profit

$66

$4,660.91

Point: Our ‘systematic’ investor averaged a compounded 4.57% per year in a ‘flat’ market while the person who made a one-time purchase was virtually at a zero return ($66 over 10 years on a $20,000 investment).

This example is presented as an illustration for educational purposes only and does not represent any investment or index. No conclusions about the future of any investment or index should be drawn from this example.

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.

You’ve heard that a thousand times. We all have. And, it doesn’t matter which decade you’re in. The 1970s, 80s, 90s, and the last ten years have all been periods of uncertainty. Whether the questions were about inflation, interest rates, tax laws, or increased market volatility, there’s been one constant:

Markets never have been, and never will be, certain of anything. I remember people back in 1991 wanting to wait until they would `know what the market was going to do’. They’re still waiting, I think.

Name a time you’ve ever heard anyone say, “Well, at last we have certainty in the markets!” I’ve never seen it; and I don’t know anyone who has, either.

Warren Buffett, someone everyone loves to quote, is famous for saying he never met anyone who could predict the stock market. He knows more people than I do. All I know is when I begin getting market advice from my dry cleaner, it does send me a message; but I digress.

Right now, everyone’s worried about congress and whether they’ll raise the debt ceiling[1]. The Democrats are doing their best to scare everyone regarding the consequences of failure, claiming the U.S. will default. The Republicans are claiming our biggest problem is the spending and borrowing more won’t help – I guess we all remember our younger days using our first credit card, so we can relate to that.

History has been filled with uncertainty and unpredictability:

Pearl Harbor

The Korean War

The Cuban Missile Crisis

The Vietnam War

The rise of the Japanese manufacturing

Mid-East Oil Crisis

Skyrocketing inflation and interest rates

Plunging interest rates

The Iranian Hostage Crisis

President Reagan walking out of the peace talks with Soviet Premier Gorbachev

The fall of the Soviet Union

That’s enough; I’m sure you can add many more to the list, including the first Iraq war, etc.

Uncertainty is not new. It’s normal.

Predicting the future worse than futile – it borders on the idiotic

And so, it should go without saying that reacting to events is not smart. It’s counter-productive.

Don’t fall for the line, “This time it’s different.” It isnt’.

The answer isn’t simplistic; but, it is simple: Those who succeed are generally those with a plan.

Your plan is like a lighthouse in a storm: No one pays much attention during fair weather; but, when the skies turn dark and storms are raging and your boat is being tossed around – when it’s hard to see through the dense fog – the lighthouse shows you the way.

It’s the one thing that isn’t moving. It’s what you depend on to get you through the uncertainty. It’s tangible.

Your plan should be tangible, too. If your financial plan is `in your head’, face it: You don’t have one. It must be tangible. It must be something you and your spouse can both see, touch, feel, and refer to when the uncertainty is all around you.

And, it always is.

Jim

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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any secrity or the services of any person or organization

[1] Just for the record, most are confusing two issues. There is a difference between meeting debt obligations – bond payments to Treasury investors – and funding spending programs. Failing to raise the debt ceiling will not result in debt default simply because Treasury revenue from current taxes is sufficient to meet those current obligations. The real issue is not credit default, but the funding of the spending programs. Without increase ability to borrow more, the government will be forced to prioritize their spending, which means cutting back on some programs which help get some politicians re-elected. Naturally, if forced to prioritize, especially during an election season, many politicians will love to see programs cut for the largest voting constituency first – pain generates letters to representatives to change their vote.

The Putnam Institute released a study recently that reached a conclusion that will surprise many clients – and advisors, too! According to their research, the optimal equity allocation for a retiree’s portfolio is about 10%! Huh?

They did say that, depending on various factors, the optimal equity allocation could be as high as 25%. Is this surprising?

Well, maybe and maybe not. While most academics and advisors consider longevity or inflation to be investors’ biggest risks – a position I have taken many times, as well – the biggest risk, according to the study, is `sequence of return’ risk! This is an issue that particularly affects investors who are withdrawing money in retirement.

Actually, this is an issue I addressed in my live program, and paper by the same name, “Why Most Retirement Plans Will Probably Fail”. For those who need retirement income from their investment portfolio, sequence of return is, indeed, a bigger risk than the raw average annual return number itself!

Let’s face it, three different investments might boast an attractive annual average return rate; but it pays to look at just how those returns were achieved. Some might provide a smoother ride than others, but not usually. Remember, it’s true: Past performance is NOT a predictor of future success. If it were, winners would be easy to spot and everyone would be rich!

(1) Make sure you have an asset allocation that’s optimized for your needs, resources, and risk profile; and,

(2) Keep an eye on your costs.

Portfolio volatility is controlled through asset allocation, not investment selection. Often, an investor will think his portfolio is diversified only to find out it’s really concentrated. Diversification is about correlation, not sectors. If you’re not sure what that means, talk to your advisor. Don’t mistake duplication for diversification.

As for costs, it doesn’t make sense to pay extra; but, it also doesn’t make sense to be penny-wise and pound foolish. I’ll never forget the story about the investor who wanted to avoid 1% in advisor fees only to lose 40% of his portfolio value because his portfolio was too heavily concentrated in his favorite stock when the market turned on him. He’ll go to his grave thinking an advisor couldn’t have done better when, in truth, few could have done worse – and the proper asset allocation would almost certainly done far better.

As you can see, proper allocation and portfolio efficiency are two important keys to your success. If you haven’t had a `portfolio stress-test’, call your advisor for a checkup.

Jim

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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any secrity or the services of any person or organization